New Zealand Treasury

Financing Infrastructure Projects:

Public Private Partnerships (PPPs)

Dieter Katz

New Zealand Treasury

Policy Perspectives Paper 06/02

March 2006
 NZ TREASURY Financing Major Infrastructure Projects: Public Private
P OLICY PERSPECTIVES Partnerships (PPPs)
PAPER 06/02

MONTH/YEAR March 2006

AUTHOR Dieter Katz

New Zealand Treasury
PO Box 3724
Wellington 6015
New Zealand
Email dieter.katz@treasury.govt.nz
Telephone (04)4715264
Fax (04)4990437

NZ TREASURY New Zealand Treasury

PO Box 3724
Wellington 6015
NEW ZEALAND
Email information@treasury.govt.nz
Telephone 64-4-472-2733
Website www. t r e a s u r y. g o v t . n z

DISCLAIMER This document was commissioned by the New Zealand

Treasury. However, the views, opinions, findings and
conclusions or recommendations expressed in it are strictly
those of the author, do not necessarily represent and should not
be reported as those of the New Zealand Treasury. The
New Zealand Treasury takes no responsibility for any errors,
omissions in, or for the correctness of, the information
contained in this paper.

ISSN 1176-9513

PP 06/02 | FINANCING INFRASTRUCTURE PROJECTS: PUBLIC PRIVATE PARTNERSHIPS (PPPS)

i
 Summary
It is often proposed that major public infrastructure projects should be
carried out as “public private partnerships” (PPPs), under which the
government franchises a private sector group to finance, build and operate
the project over a substantial part of the infrastructure’s economic life (often
30+ years).

The main benefits usually attributed to PPPs are accelerated provision of

infrastructure projects as a result of using private sector finance, and better
value for money due to private sector innovation and whole-of-life cost
minimisation, than can be obtained under conventional private sector
procurement.

This paper argues that

• There are other ways of obtaining private sector finance without having
to enter into a PPP;

• most of the advantages of private sector construction and management

can also be obtained from conventional procurement methods (under
which the project is financed by the government, and construction and
operation are contracted out separately);

• the advantages of PPPs must be weighed against the contractual

complexities and rigidities they entail. These are avoided by the periodic
competitive re-tendering that is possible under conventional
procurement.

The paper concludes that PPPs are worthwhile only if all three of the
following conditions are met:

1. The public agency is able to specify outcomes in service level terms,

thereby leaving scope for the PPP consortium to innovate and optimize.

2. The public agency is able to specify outcomes in a way that

performance can be measured objectively and rewards and sanctions
applied.

3. The public agency’s desired outcomes are likely to be durable, given

the length of the contract.

PP 06/02 | FINANCING INFRASTRUCTURE PROJECTS: PUBLIC PRIVATE PARTNERSHIPS (PPPS) ii

 Contents

Summary.......................................................................................................ii

Introduction .................................................................................................. 1

What is a PPP?............................................................................................ 2

New Zealand Law and Practice ................................................................... 3

Advantages of PPPs .................................................................................... 4

Disadvantages of PPPs ............................................................................... 7

Value for Money Test................................................................................... 8

Conclusion ................................................................................................... 9

References................................................................................................. 10

Appendix: Auckland Indoor Arena ............................................................. 11

PP 06/02 | FINANCING INFRASTRUCTURE PROJECTS: PUBLIC PRIVATE PARTNERSHIPS (PPPS) iii

 Financing Infrastructure
Projects: Public Private
Partnerships (PPPs)

Introduction
This paper concerns itself with infrastructure concession agreements,
under which a government agency awards a long-term contract to a private
PPPs are said to bring party to design, build and operate a facility that provides services either to
projects forward and offer the public or back to the government agency. Typical examples from
better value for money. overseas would include toll roads, prisons, stadiums, water treatment
plants and military training facilities.

While few public private partnerships of this kind (PPPs1) have been
undertaken in New Zealand, they have been popular in a number of
countries for advancing the construction of large public infrastructure
projects. They are said to offer “the potential to bring forward projects and
free up public funds for other projects”2 and “offer the potential for
government agencies to achieve better value for money through value
drivers such as improved risk sharing, innovation, better asset utilisation
and the adoption of commercial production and management practices”.3

This paper discusses the main advantages and disadvantages of PPPs

with particular regard to institutional circumstances in New Zealand.

PPPs are very complex and this paper cannot do justice to all the issues
they give rise to.4 Moreover, PPPs have been and continue to be
controversial. Attention is drawn to the disclaimer on page i which is
particularly pertinent in the case of this paper.

1
Sometimes also known as private finance initiatives (PFI).
2
The Independent, 11 December 2002.
3
Senator Nick Minchin, Australian Minister of Finance and Administration, June 2002.

4
A fuller treatment can be found, for example, in Webb and Pulle (2002), Osborne (2000),
Fiscal Affairs Department (2004), de Bettignies and Ross (2004) and in a recent
publication by the Office of the Auditor General (2006).

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 What is a PPP?
PPPs can take many forms, but the minimum characteristics of a PPP of
the kind discussed in this paper are the following:

• A public agency enters into a contract with a private company or

PPPs are whole-of-life
contracts for the financing,
construction and operation
of infrastructure facilities.
consortium to provide finance and arrange design, construction and on-
going operation of a facility (‘on-going operation’ might involve provision
of full services or it might only involve providing maintenance of the
facility, with services to the public being provided by a government
agency);

• The contract is typically for 20-30 years, or a substantial part of the life of
the facility;

• At the end of the contract, control of the facility is usually returned to the
government or a local authority.

Typically, a government agency will specify the outputs or services

required. The job of producing detailed designs, finding the finance,
organizing the construction and on-going management of the facility is let to
a private consortium by way of a competitive tender. The private
consortium is typically organized by a lead contractor who brings together
financiers, engineering firms, construction companies and facilities
management companies, etc, to provide individual services.

For a project to be a PPP as defined in this paper, all of these elements

need to be carried out by the private sector. If coordination and financing
are carried out by a public sector agency but, all other elements are carried
out by the private sector, then the arrangement can be called “conventional
private sector procurement”. The following illustrates this distinction:

Conventional Private
PPP Sector Procurement
Public Treasury Public
Agency (financier) Agency

Financier Consortium

Design & Operation & Design & Operation &

Construction Maintenance Construction Maintenance

To complete the picture, “public sector provision” describes the situation

where the remaining elements, and in particular the operation of the
infrastructure, are also carried out by a public sector agency.

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 This paper does not
evaluate PPPs against
public sector provision, but
against conventional private
sector procurement, under
which the Crown provides
the finance, and
construction and operation
are contracted out
separately.
There have been few PPPs
in New Zealand.
There are some instances
of delivery of public services
by the private sector
(conventional private sector
procurement), but these are
not widespread either.
PP 06/02 |
The point to note here is that public sector provision is not the only
alternative to PPPs. Where a PPP is politically acceptable to the
government, then presumably “conventional private sector procurement”
will also be acceptable.
Some of the advantages normally ascribed to PPPs, such as risk transfer,
the introduction of private sector expertise and private sector performance
incentives, are obtainable to a large extent also under conventional private
sector procurement. It is not the purpose of this paper to evaluate
conventional private sector procurement against public sector provision.
The purpose of this paper is to evaluate the merits of replacing
conventional private sector procurement with a PPP, i.e. to evaluate the
distinction drawn in the above illustration.
New Zealand Law and Practice
Generally, there are no legal barriers to entering into PPPs except as
follows:
• The Corrections Act 2004 prohibits the Crown from entering into any
contract for the management of any prison.
• Section 130 of the Local Government Act 2002 prohibits PPPs for water
and wastewater services.
• The Land Transport Management Act 2003 imposes procedural
restrictions on roading PPPs.
There have been very few New Zealand PPPs of the kind described above,
but one example is described in the appendix. There have been no
substantial PPPs entered into by a central government agency.
New Zealand no longer has a Ministry of Works. Design and construction
is almost always contracted out to the private sector. While operation and
maintenance is often carried out by the public sector, this is certainly not
always the case. For example, Transit New Zealand (the public agency
responsible for building and maintaining state highways) contracts out all
maintenance of state highways, as well as design and construction.
Another example is the Auckland Central Remand prison, the operation of
which was contracted out in 2000.5
5
The management contract was not renewed in 2005 as a result of the Corrections Act
2004.
FINANCING INFRASTRUCTURE PROJECTS: PUBLIC PRIVATE PARTNERSHIPS (PPPS) 3
 Advantages of PPPs
Better whole-of-life project evaluation: Under conventional procurement,
individual private sector companies do not evaluate the whole-of-life
Compared with conventional
viability of a project because they are only invited to tender for portions of
procurement, the
the project. The whole-of-life assessment is carried out by a public agency
advantages of PPPs are… which doesn’t normally bear the financial consequences of getting it wrong
to the same extent as a consortium in a PPP would.

Public sector assessments often suffer from an optimism bias. (While the
same is also true for many private sector projects, it is probably difficult to
…better whole-of-life project establish empirically whether, or the extent to which, public6 sector projects
suffer more from optimism bias than private sector projects) . Under a PPP
evaluation,
the private sector has arguably a stronger incentive than a government
agency to be realistic about the prospects of a project. This is because of
the considerable financial investment the consortium has put at risk. One
would expect the private sector not to submit a tender if the business case
does not stack up.

It seems clear that there are stronger incentives to correctly identify the
whole of life costs of construction and operation, and the likely revenue
stream, under a PPP, if project risk is transferred to the private sector.

Optimization of design and operation in order to minimize whole-of-life

costs: Under a PPP, if the designers and builders have a financial stake in
the project over its whole life, they will have an incentive to design features
and construction standards so they are optimized against the long-term
cost of maintenance and operational requirements. The incentives to do so
are likely to be stronger than under conventional procurement.

…stronger incentives to The extent to which better optimization will result depends on a number of
innovate and minimize factors:
whole-of-life costs,
• The state of knowledge about construction methods and long-term
maintenance and operational requirements. Where a public agency
undertakes many similar projects, such as Transit NZ, there may be less
scope for innovation and optimisation than in the case of more
specialised projects that are done on a one-off basis, e.g. a city council
contracting for a water treatment plant.

• The extent of scope given to the PPP consortium to vary designs and
innovate. The scope is greater when the public agency specifies its
requirements in terms of service levels. The less it can do so, i.e. the
more it specifies the contract in input terms or in terms of physical or
engineering specifications, the less scope there is for the private sector
to achieve whole-of-life efficiencies beyond those already obtained by
the public agency in developing its contract specifications. For example,
the public agency may find it difficult to define a motorway project in a

6
This author is not aware of any credible studies on this point.

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… and access to additional
capital without affecting the
gross debt target,
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dense urban setting by way of service level specifications only. Poorly
defined service level specifications could leave too much room for the
private sector party to minimize costs at the expense of the traveling
public or adjoining properties. The public agency may therefore choose
to define the project in a way that leaves little room for innovation and
whole of life optimization.7
• The extent to which the public sector agency, under conventional
procurement, is influenced by budgetary considerations or other objectives.
For example, under conventional procurement, budget constraints may
lead to cheap construction at the expense of future increased operation
and maintenance costs. Or, if the Government’s capital budget is less
constrained than its operating budget, the agency may over-specify at the
design stage in order to keep future operating costs down.
In sum, the scope for private sector innovation and whole-of-life optimization
(relative to conventional procurement) is another advantage of transferring risk
to the private sector. But sometimes it will be not very significant.
Access to additional capital: The government does not have to provide capital
in the case of PPPs. This can be an advantage where the government has a
poor credit rating and is not able to raise finance, and where financial markets
cannot readily distinguish between general government borrowing and
government borrowing for a specific revenue-earning infrastructure project.
This is not at present an issue in New Zealand.
In any case, where the infrastructure relies for its revenue on a public
agency paying a user fee (e.g. prisons), then it is likely that the PPP
financier will face no better credit rating for this project than the
government, and is not, therefore, likely to have better access to capital,
even if the government has a poor credit rating.
Off-balance sheet financing: When people say that PPPs will give access to
more capital, i.e. will bring forward projects and free up public funds for
other projects, they usually mean that PPPs are a way of financing projects
without breaching the government’s self-imposed borrowing limit. This
appears to have been the motivation for PPPs in the UK and in Australia, at
least in the early days.
The New Zealand Government must maintain prudent levels of total debt.8
To manage total debt at prudent levels the Government focuses on
ensuring SOEs have debt structures that achieve best commercial practice
and has a self-imposed borrowing limit in the form of a gross sovereign-
issued debt target. 9 PPPs could provide the opportunity to raise funds
beyond what would be normally possible under the gross sovereign-issued
debt target.
7
See also the discussion below on performance enforcement.
8
Section 26G of the Public Finance Act.
9
Budget Policy Statement 2005.
FINANCING INFRASTRUCTURE PROJECTS: PUBLIC PRIVATE PARTNERSHIPS (PPPS) 5
 Financing public projects without breaching the government’s sovereign-
issued debt limit (referred to here as off-balance sheet financing) is feasible
where projects are financed from 3rd party revenue, such as toll roads.

This is more difficult in the case of infrastructure that does not earn revenue
from third parties, such as prisons, and roads financed from “shadow
tolls”.10 In such situations the Crown typically bears the demand risk.
While accounting rules are in a state of flux on this point,11 it appears that
where the demand risk is not transferred, financial liabilities arising from
obligations under a PPP contract would need to be recorded on the
Crown’s balance sheet irrespective of who raised the capital.12

Note, if the Crown finances a project that would have been viable as an
… but this can also be unsubsidised PPP, the debt would be matched on its balance sheet by a
achieved in other ways than corresponding asset, namely the value of the income stream accruing to
the infrastructure (e.g. a toll road). The net worth of the Crown is not
by entering into a PPP.
immediately affected, although the set of financial risks faced by the Crown
does change. The higher gross debt does not, therefore, reflect a higher
economic burden on tax payers. In any case, the higher debt gradually
reduces back to zero over the life of the asset. In such cases, there may
be a case for treating the debt in the same way as SOE debt structures,
and there may be ways of managing public perceptions of increased debt
by, for example, reporting investments in income-earning assets separately
from other assets.

The example of SOEs illustrates the point that there are other ways of
managing concerns about the effect on gross debt than by entering into a
PPP. These should be considered alongside any proposal to enter into a
PPP, if the motivation for the PPP is to finance income-earning
infrastructure without putting pressure on the government’s gross debt
target (i.e. off-balance sheet).

Assurance of good maintenance: The whole-of-life approach and the

contractual obligations around maintenance ensure that it is fully
maintained throughout its life. This is not always the case under the direct
management of a public agency, where maintenance needs are sometimes
subordinated to other priorities.

In the case where a public agency is the user (such as a schools PPP), this
‘advantage’ is a double-edged sword: a contractual obligation to provide the
money for maintenance comes at the cost of reduced budget flexibility, yet
limited deferment of maintenance need not always harm an asset unduly.

10
Under a shadow toll, the number of vehicles using a road is counted, and the toll is paid
by the government.
11
See Office of the Auditor-General (2006) and Davies P and Eustice K (2005).
12
Davies P and Eustice K (2005).

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 Disadvantages of PPPs
Disadvantages include… Tendering and negotiation: PPP contracts are typically much more
complicated than conventional procurement contracts. This is principally
because of the need to anticipate all possible contingencies that could arise
in such long-term contractual relationships. Each party bidding for a project
…the very large tendering
spends considerable resources in designing and evaluating the project prior
and contracting costs,
to submitting a tender. In addition, there are typically very significant legal
costs in contract negotiation. Having several bidders do this involves a cost
which can add up in total to tens of millions. It has been estimated that
total tendering costs equal around 3% of total project costs as opposed to
around 1% for conventional procurement.13 The cost of both successful
and unsuccessful bids is, in effect, built into total project costs. The
Australian Council for Infrastructure Development has expressed the view
that “unless tendering processes are well run it is possible that the benefits
of using a PPP for delivering the project may be outweighed by the
tendering costs”.14 Under conventional procurement, the sunk costs of
private contractors are much smaller and contracts (e.g. for operations)
often do not exceed 5 years. The risks to be covered off in the contract are
therefore significantly less.

Contract renegotiation: Given the length of the relationships created by PPPs

and the difficulty in anticipating all contingencies, it is not unusual for aspects
of the contracts to be renegotiated at some stage. Wherever possible,
… the costs of contract re- provisions are included in the contract that spell out how variations are to be
negotiation, which are often priced. But, given the length of time spanned by the contract, it is almost
high, inevitable that circumstances will arise which cannot be foreseen.
Where the need for renegotiation comes from the public agency (which, it
appears, is often the case, perhaps as a result of a change in government
policy) and no pricing rule is contained in the contract, the Crown can end
up paying a heavy price, since the price is not determined in a competitive
bidding context. The cost of such changes is difficult to factor into the
original project evaluation, since by definition it is unanticipated.

Performance enforcement: One of the difficulties with performance

specification in the area of service delivery is that performance sometimes
… the difficulties of ensuring
has dimensions which are hard to formulate in a way that is suitable for an
good performance,
arms-length contract. Examples include maintaining good customer
especially with respect to relations, and not creating public relations blunders which rebound on the
“soft” performance government. In the case of building a motorway through a dense urban
dimensions, setting, a public roading authority will sometimes find it difficult to specify all
performance elements in service level terms.

13
See BEC and Sir Michael Latham, Constructing the team, reproduced in Dr Eamonn
Butler & Allan Stewart MP, Seize the Initiative, Adam Smith Institute, 1996, quoted in
Grahame Allen (2001), p.34.
14
Australian Council for Infrastructure Development, Australia at a Crossroads
Public/Private partnerships or Perish?, quoted in Webb and Pulle (2002).

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… and the difficulty for the
government not to intervene
if the provider threatens to
go bankrupt.
The “public sector
comparator” used in some
other countries is a useful
tool, but is not evidence that
a PPP is superior to
conventional private sector
procurement.
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The reputation effect and the prospect of repeat business can sometimes
provide incentives to achieve “soft” performance targets. For example,
unsatisfactory performance by a prison management company will affect its
reputation and therefore its ability to obtain contracts elsewhere.
However, in other cases neither reputation effects nor contractual remedies
will be sufficient. A “command” relationship or “master-servant” relationship,
such as exists within an organisation, may be more efficient. In essence, if
for whatever reason one isn’t able to clearly specify the required services,
then a master-servant relationship enables one to change the service
requirement as one goes along, at relatively little cost.15 At the construction
stage, a project alliance approach may be most appropriate, while at the
infrastructure operation stage a series of short-term contracts may be
acceptable as they provide the opportunity for the public agency to take
corrective action if it finds that some performance dimensions were
inadequately specified or no longer appropriate given changing public
expectations.
Political acceptability: Given the difficulty in estimating financial outcomes over
such long periods, there is a risk that the private sector party will either go
bankrupt, or make very large profits. Both outcomes can create political
problems for the government, causing it to intervene. Examples of the former
include the National Air Traffic Services (NATS), which encountered financial
difficulties after 11 September 2001. The British government bailed it out
rather than let NATS’ bankers take it over. Another example is Melbourne’s
tram and train services, contracted out in 1999. Patronage didn’t increase to
the levels expected, causing the operator to threaten to fail. The government
agreed to increase the operating subsidy.
Both kinds of risk are often reduced by including in the contract loss sharing
or profit sharing provisions. But such provisions reduce the extent of risk
transfer, and therefore the advantages of PPPs.16
Value for Money Test
Some jurisdictions, e.g. Victoria and the U.K., require the establishment of
a “public sector comparator” against which a PPP is evaluated.
This “value for money” test is, however, problematic. In particular, it is
difficult to factor in the cost of things going wrong over the total life of the
project. More generally, the public sector comparator is necessarily
hypothetical, so its credibility is difficult to test.
15
There is an extensive literature on the choice between entering into explicit contracts and
coordinating activities via a command relationship. This is loosely known as the “theory
of the firm”. See, for example, O. Williamson (1980).
16
Ehrhardt D and Erwin T (2004)
FINANCING INFRASTRUCTURE PROJECTS: PUBLIC PRIVATE PARTNERSHIPS (PPPS) 8

A PPP may be a good way
of procuring services only if
three conditions are met:
Project outcomes can be
specified in service level
terms, performance can be
measured objectively and
performance objectives are
durable.
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It should not be surprising that there has been much debate about whether
PPPs offer value for money. The limited available empirical evidence
favours PPPs. For example, HM Treasury concluded that of 61 PFI
projects, 89% were delivered on time or early and all were delivered within
public sector budgets.17
But, aside from the problems with the public sector comparator, these
studies suffer from the fact that few PPPs are more than one third through
their lives.
Conclusion
There is little reliable empirical evidence about the costs and benefits of
PPPs. This paper has therefore made a qualitative assessment.
It concludes that the more complete transfer of risk that is possible under a
PPP, results in better project evaluation and stronger incentives to innovate
and minimize whole of life costs. But these advantages must be balanced
against the large contract negotiation costs, the inflexibilities of a long-term
contract and the reduced competitive pressures on performance after the
contract has been entered into (compared with a situation where the
contract is re-tendered periodically over the life of the infrastructure).
The decision whether to proceed with a PPP rather than with a
conventional procurement process turns principally on the following three
questions:
1. Is the public agency able to specify outcomes in service level terms,
thereby leaving scope for the PPP consortium to innovate and
optimize?
2. Is it easy for the public agency to specify outcomes in a way that
performance can be measured objectively and rewards and sanctions
applied?
3. Are the public agency’s desired outcomes likely to be durable, given the
length of the contract?
If the answer to any of these three questions is “no”, then conventional
procurement is likely to be preferable to a PPP.
17
HM Treasury (2003)
FINANCING INFRASTRUCTURE PROJECTS: PUBLIC PRIVATE PARTNERSHIPS (PPPS) 9
 References
Davies P. and Eustice K. 2005 “Delivering the PPP promise: A review of
PPP issues and activity.” PriceWaterhouseCoopers.

Ehrhardt D. and Erwin T. 2004 “Avoiding Customer and Taxpayer Bailouts

in Private Infrastructure Projects.” World Bank Policy Research Working
Paper 3274.

Grahame Allen 2001 “The Private Finance Initiative (PFI).” House of

Commons Library Research Paper 01/117.

HM Treasury 2003 “PFI: meeting the investment challenge.”

Osborne S. B. (Ed) 2000 Public-Private Partnerships: Theory and Practice

in International Perspective. Routledge.

Fiscal Affairs Department 2004 “Public-private Partnerships.” International

Monetary Fund.

de Bettignies, Jean-Etienne and Ross, Thomas W. 2004 “The Economics

of Public-Private Partnerships.” Canadian Public Policy – Analyse de
Politiques, vol. XXX, no. 2.

Office of the Auditor-General 2006 “Achieving Public Sector Outcomes with

Private Sector Partners” Wellington, New Zealand.

Webb R. and Pulle B. 2002-2003 “Public Private Partnerships: an

Introduction.” Research Paper no. 1, Parliamentary Library,
Commonwealth of Australia.

Williamson O.E. 1980 “The organisation of work: a comparative institutional

assessment.” Journal of Economic Behaviour and Organisation, 1, 5-38.

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 Appendix: Auckland Indoor Arena
The Auckland Indoor Arena, an entertainment and sporting events centre,
is a PPP entered into by the Auckland City Council in May 2004.

Quay Park Arena Management has agreed to build, own, operate and
maintain the Arena for 40 years, when ownership of the building and the
operating systems will be transferred to the Council. Construction is
currently in progress.

As the arena was not commercially viable, the Council provided a subsidy
by way of a contribution of $68.2 million towards the capital cost of $80
million.

Quay Park Arena Management has put up the remaining $11 million. It will
be entitled to revenue from ticket sales and venue rentals. The agreement
provides for the Council to receive royalties, which will in part be used to
fund community events at the Arena. However, there is no guarantee that
royalties will be received.

The main reason for choosing a PPP approach was that the Council does
not understand and has no experience in operating a major events venue.
Under the agreement, the private sector partner, which has the experience
and skills to run this type of business, is responsible for operations and
carries the operational risk.

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